Hedge Fund
Also written Hedge fund (historical) · Hedge Fund (AIF Regulations) · Hedge funds
A pooled vehicle using diverse or complex trading strategies, long and short positions and fund-level leverage — in India, the AIF Regulations place hedge funds in Category III.
In plain language
A hedge fund is a pool of investors' money run with far fewer restrictions on what the manager may do than a mutual fund.
The workbook picks out three things that separate it from other AIFs:
- It can invest across asset classes — financial assets, currencies, complex derivatives.
- It uses complex strategies such as arbitrage and carry trade, producing variable outcomes and complex risk patterns.
- It takes both long and short positions and uses significant leverage at fund level — the fund itself borrows to invest.
The name comes from the third point. The ability to go both long and short across markets is what gave these funds the name "hedge funds". But the workbook is blunt that the same breadth is what makes them speculative and highly susceptible to capital at risk. A hedge fund is not a hedged fund.
SEBI's definition, repeated in Chapters 2 and 4: an AIF which "employs diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products including listed and unlisted derivatives".
How it works
History (Chapter 4, section 4.1). The term first came into use in 1949, when Alfred Winslow Jones's company, A.W. Jones & Co., launched the first hedge fund. Hedge funds were described as any fund that used incentive fees, short selling and leverage to maximise returns.
India before 2012. Foreign investors reached Indian markets through offshore hedge funds and funds of funds, investing directly or through Offshore Derivative Instruments. No hedge funds were domiciled in India, and offshore funds could not market to Indian investors because there was no regime for it. SEBI gave a limited window up to 2012 to register as an FII with safeguards. Under the SEBI (AIF) Regulations, 2012, hedge funds were classified as Category III AIFs.
The Category III guard-rails that shape the strategy:
- Leverage may not exceed 2 times NAV, where leverage = total exposure (long + short, after permitted offsetting) ÷ NAV, calculated at scheme level.
- A Category III AIF may invest not more than 10% of its investable funds or NAV in one investee company (20% for Large Value Funds).
Leverage at fund level, in the workbook's footnote, means the fund entity borrows from market sources to invest, hoping gains exceed the cheaper cost of debt — but the debt must be repaid whatever happens to the investments, which is why hedge funds sit at the higher-risk end of AIFs.
The formula
Leverage = Total exposure (long positions + short positions, after permitted offsetting)
÷ Net Asset Value
Category III limit: Leverage ≤ 2
A worked example
The workbook's own illustration: a Category III AIF with NAV of Rs 50 crore may carry total exposure, after offsetting, of no more than Rs 100 crore.
Suppose the manager builds this book (positions are in unrelated stocks, so nothing offsets):
| Position | Market value |
|---|---|
| Long positions | Rs 70 crore |
| Short positions | Rs 25 crore |
| Total exposure | Rs 95 crore |
Leverage = 95 ÷ 50 = 1.9 times → within the 2× limit
The manager then wants to add Rs 10 crore of longs and Rs 5 crore of shorts:
New exposure = 80 + 30 = Rs 110 crore
Leverage = 110 ÷ 50 = 2.2 times → breach
Notice that short positions add to exposure; they do not net against longs unless the SEBI offsetting rules allow it. A long-short fund that thinks of itself as "net Rs 50 crore long" is still measured on the gross Rs 110 crore.
The concentration limit bites separately: 10% of Rs 50 crore is Rs 5 crore in any single investee company.
Why NISM asks about it
Chapter 2, section 2.3.3, gives the three distinguishing features and SEBI's definition; section 2.6.1 covers the global market (funds of funds, multi-strategy funds, CTAs). Chapter 4, section 4.1, gives the 1949 A.W. Jones origin and the path to Category III; section 4.2.3 repeats the regulatory definition. Chapter 10 then works through the actual strategies — long-short, market-neutral, convertible and merger arbitrage — and Chapter 15 supplies the 2× leverage cap. Expect the definition verbatim, the year 1949, and a leverage calculation.
Common exam traps
- "Hedge fund" does not mean the fund is hedged. The workbook calls these funds speculative and highly susceptible to capital at risk. The name comes from the ability to go both long and short.
- First hedge fund: 1949, A.W. Jones & Co. Not 1929, not the 1990s.
- In India, hedge funds are Category III AIFs — not Category II, and there is no separate "hedge fund" registration.
- Leverage counts gross exposure. Long plus short, after only the offsetting SEBI permits. Net exposure is not the test.
- The cap is 2 times NAV, not 2 times corpus or commitments.
- Before 2012 there was no Indian hedge fund regime; the limited window was FII registration, not AIF registration.
Where this is taught
- Series XIX-B · Chapter 1: Overview of Alternative Investmentsintroduced here
- Series XIX-A · Chapter 1: Overview of Alternative Investmentsintroduced here
- Series XIX-C · Chapter 2: Types of Investmentsintroduced here
- Series XIX-E · Chapter 4: Alternative Investment Funds in India and its Suitabilityintroduced here
- Series X-A · Chapter 13: Overview of Alternative Investment Funds (AIFs)introduced here
Related terms
- Category III AIFThe AIF category for funds running diverse or complex trading strategies with leverage — hedge funds and their kin — and the only category denied tax pass-through status.
- Fund of fundsAn AIF that invests in the units of other AIFs rather than directly in investee companies — buying diversification across managers and strategies, and paying two layers of fees for it.
- LeverageControl of a large contract value for a small upfront outlay — premium for an option buyer, margin for a futures position — which multiplies percentage gains and percentage losses by the same factor.
- Long-Short Equity StrategyA Category III AIF strategy that buys stocks the manager thinks are under-priced and shorts those it thinks are over-priced — often run as a 130/30 fund with 100% net market exposure.
- Market-Neutral StrategyA Category III AIF strategy taking equal long and short exposures within a sector, industry or market-cap segment so that portfolio beta is zero or close to zero.
- Convertible ArbitrageA Category III long-short strategy: buy a company's convertible bond or preference share and short its equity, to profit when the conversion terms and the share price fall out of line.
- Merger ArbitrageAn event-driven Category III strategy: go long the target company and long or short the acquirer, to capture the gap between the target's price and the deal price as a merger completes.
- Liberalised Remittance SchemeThe RBI facility letting a resident individual remit up to USD 250,000 per financial year abroad for any permissible current or capital account transaction, including investment in offshore funds.
- Alternative InvestmentA financial asset outside the conventional categories of stocks, bonds and cash — defined by what it is not, and marked above all by illiquidity.
- Convergence TradeA relative-value trade that buys relatively under-valued bonds and sells relatively over-valued ones, betting their prices converge. The gaps are tiny, so profits need heavy leverage — LTCM's undoing.
- Alternative Investment FundA privately pooled investment vehicle registered with SEBI that raises money from select Indian or foreign investors under a defined investment policy — never from the public at large.
- Distressed securitiesEquity, bonds or trade debt of a company that is near or in bankruptcy, or has suffered a massive credit-rating fall, trading at a steep discount because regulated investors are forced to sell.